Parabolic SAR (Stop and Reverse) Indicator

What it is

The Parabolic SAR (PSAR), developed by J. Welles Wilder, is a technical indicator used to identify trend direction, signal potential reversals, and provide a trailing stop level. It plots a series of dots on price charts: dots below price during uptrends and above price during downtrends. When the dots flip sides, the PSAR signals a change in the price–indicator relationship.

How to read the signals

• Buy signal: dots move from above price to below price.
• Sell signal: dots move from below price to above price.
• Trailing stop: use the PSAR dots as a dynamic stop-loss level—exit a long if price closes below a rising PSAR, or exit a short if price closes above a falling PSAR.
• Important nuance: a PSAR reversal means the price crossed the indicator, not necessarily that the market has completed a genuine trend reversal.

Formula

Rising PSAR:
RPSAR = Prior_PSAR + (Prior_AF × (Prior_EP − Prior_PSAR))

Falling PSAR:
FPSAR = Prior_PSAR − (Prior_AF × (Prior_PSAR − Prior_EP))

Where:
* AF (Acceleration Factor) — starts at 0.02 and increases by 0.02 whenever a new extreme point (EP) is made, up to a typical maximum of 0.20.
* EP (Extreme Point) — in an uptrend: the highest high since the trend began; in a downtrend: the lowest low since the trend began.
* Prior_PSAR, Prior_AF, Prior_EP — values from the previous period.

How to calculate (practical steps)

1. Establish initial direction and record highs/lows for at least five periods to set starting values.
2. For an initial uptrend, use the lowest low of those periods as the initial Prior_PSAR; for an initial downtrend, use the highest high.
3. Set AF = 0.02. Increase AF by 0.02 each time a new EP (higher high in uptrend or lower low in downtrend) occurs, up to the max (commonly 0.20).
4. Compute the next PSAR using the rising or falling formula. If price closes beyond the computed PSAR, switch to the opposite formula and reset EP and AF appropriately.
5. Track PSAR, EP, and AF period by period (spreadsheets can help), though charting platforms typically calculate PSAR automatically.

Trading strategies and best practices

• Use PSAR to trail stops and manage exits—its automatic switching ensures a position is always defined (long or short).
• Confirm PSAR signals with trend-strength indicators (e.g., ADX), moving averages, or trendlines to avoid noise in sideways markets.
• Example confirmation: take PSAR buy signals only when ADX indicates a strong trend (commonly ADX > 25–30) or when the price is above a longer-term moving average.
• PSAR is most effective in trending markets where sustained moves allow the AF to capture momentum; avoid relying on PSAR alone in range-bound conditions.

PSAR vs. Moving Averages

• Moving averages (MA) smooth price by averaging over periods and highlight general trend direction.
• PSAR uses extreme highs/lows and an acceleration factor to produce point-by-point stop levels and reversal signals.
• They produce different signals and visual patterns; many traders use both for complementary perspectives (MA for trend direction, PSAR for trailing stops/reversals).

Limitations

• PSAR continuously generates signals, even in non-trending markets, which can lead to frequent false reversals and small losses.
• The acceleration factor causes the PSAR to “catch up” to price over time, so reversals may be triggered even without a true change in trend.
• Reversal signals can prematurely exit profitable trades or produce whipsaws in choppy markets.
• Always consider confirming indicators and position sizing to manage the risk of false signals.

Key takeaways

• PSAR provides dot-based signals and trailing stop levels that change side when price crosses the indicator.
• It is best used in trending markets and as part of a broader trading plan with confirmations.
• Understand AF and EP mechanics—charting software handles calculations, but interpret signals with caution to avoid whipsaws.